Regarding… Vol 2 no 36 – Schrodinger’s China

Dear Fellow Investors and Friends,

Welcome to this week’s edition of my investment musings, where I try to make sense of the world around me and share stuff that I find interesting. I just got back from two weeks away – more on that later – so there is a lot to discuss.

Today is Thursday, October 3rd, the 277th day of the year. There are 89 days left until the end of the year. We’re into double digits, people!

This week is the Chinese National Day Golden Week, a week-long holiday celebrated with the National Day of the People’s Republic of China, marking the nation’s founding in 1949.

Chinese investors can happily take the week off, secure in the knowledge that their portfolios have just gained 25% over the past six days:

For a long time, I regarded China as being uninvestable. In a nutshell, my reasons were as follows:

• China maintains strict exchange controls. If China must force its people to keep their money at home, why would foreign investors willingly put their money at risk there?
• China is experiencing a negative population growth rate. That can’t be good for long-term economic growth.
• The capex boom in China over the past twenty years has led to significant overcapacity in many industries, most notably housing. Economic growth will take a long time to mop up this oversupply, which will dampen potential growth rates in the meantime.
• Until about two years ago, valuations were extreme, almost bubble-like. The market was assuming that growth rates would continue at a high level for a very long time, and the capex boom would never end. There would be no competitive dynamics, government intervention or even twists of economic fate that could halt this growth miracle. Investors had swallowed another “perpetual growth story” hook, line, and sinker.

These reasons were all based on market dynamics and fundamental valuation measures. But my main objections weren’t economic but existential:

• China is an economy with “capitalist characteristics”, but, at heart, it remains a communist system. Ownership rights are not as well entrenched as one might hope.
• Related to this – as far as I know – there is no legislation around corporate governance. Companies do what the government allows them to do. These rules change from time to time. I have yet to come across any kind of shareholder-related corporate action, successful or otherwise.
• CEOs of significant corporations disappear from the scene from time to time. So, when it comes down to it, I’m not sure “shareholder rights” will count for anything.
• Speaking of which, most Western “shareholders” of Chinese companies don’t own equity in the underlying businesses. Their ownership is via something called a VIE, or Variable Interest Entity. VIEs are simply contracts between the holder and an offshore entity that entitles the holders to certain cash flows from the Chinese company without having voting rights. My main gripe here is not the nature of the contractual arrangements themselves but that these contracts have not yet been tested in a court of law. Also, I don’t understand what the “Variable” stands for, but I’m pretty sure that under certain circumstances, it won’t turn out to be a good thing.
• Finally, Russian shares were effectively zeroed out of investors’ portfolios after the Invasion of Ukraine and subsequent Western sanctions. What happens when/if China invades Taiwan?

These factors could seriously impair or even wholly extinguish one’s investment with the stroke of a communist official’s pen. How much of your portfolio should you allocate to an overhyped, expensive market with significant existential risk?

For a long time, I believed the correct percentage to allocate was 0.

Even with this background, it surprises many that China has been one of the worst places in the world to invest over time. Despite last week’s bounce, returns look poor over the long term:

Given this rally, what is my view today?

It is fair to say I have softened my stance somewhat, mainly due to improving valuations, which do not reflect some of the positive aspects of the Chinese economy:

• China is fast developing a technological edge over the rest of the world. For instance, China now accounts for 47% of global patent applications. It is on the road to designing and producing substantially all its semiconductor needs within the next decade. China’s electric vehicles outsell Tesla at a lower price. It has the most significant high-speed rail network in the world. And so on.
• All these add up to the potential for continued productivity gains. Population growth multiplied by productivity advances generally determines GDP growth. As mentioned earlier, China has the economic headwind of a declining population, which can be offset by a tailwind of productivity enhancements through technological advances.
• Despite the current economic slowdown, China is a massive market and will remain relevant globally.
• Notably, China’s growth aspirations are unconstrained by the Malthusian ideals which have taken root in the West. Its political system allows it to exploit all the resources it needs, thereby creating an environment conducive to real economic gains on a per capita basis.

Finally, there is the technical factor brought about by the rise of indexing. If one assumes most investors are either fully indexed or at least “index aware” in their portfolio allocations, the following are important numbers to take note of:

• The USA is 20% of global GDP.
• US stocks comprise 63% of the MSCI ACWI (All Country World Index), the most referenced global index.
• China is 33% of global GDP.
• Chinese stocks make up 2,8% of the MSCI ACWI.

Murray Stahl of Horizon Kinetics outlined the situation investors face: “Indexation is supposed to be the holistic solution to the idiosyncratic risk, or security selection, problem. All competitors in each industry are in the same portfolio, which is the index. One company’s decline is balanced by its more successful competitor’s rise. The only big risk is systemic. However, China is almost wholly outside the index, so it defines exogenous systemic risk. On the one hand, it’s very substantial growth potential won’t be captured by the index. On the other, whatever creative destruction it inflicts on the index can’t be offset by the success of Chinese equities.”

So, one of the most significant risks investors face today is China’s rise as a successful competitor to the USA. If Chinese companies compete successfully against US multinationals, the index and, thus, most investors’ portfolios will not capture this.

There are a couple of ways to play this. Ranked from indirect to direct, these are a few of them:

• South Africa’s economic prospects are closely linked to those of China. As goes China, so goes SA. The MWI Value fund would be a big beneficiary of continued gains in the Chinese market.
• Buying the iShares MSCI Emerging Market Index ETF, which has 23% exposure to Chinese stocks (this is what the MWI Worldwide Flexible Fund – aka “the cockroach” has done).
• Buying Prosus (and indirectly Naspers), which owns a significant stake in Tencent, one of the world’s best companies. This could be a good idea if you don’t mind single stock risk coupled with capital misallocation risk.
• Buying a dedicated country fund like the Cederberg Greater China Equity fund. This fund is run by a team led by wonderful South African investor Dawid Krige and is worth investigating.

Finally, although the fundamental outlook for Chinese stocks is more favourable now than it has been for a long time, the existential risks remain undiminished. It would be sensible to size your position accordingly. Like Schrodinger’s cat, it exists in two states simultaneously. You will only know the actual state once it’s too late to do anything about it.

During my absence, markets were firm. This reminds me that I should go away more often! Broad equity measures like the S&P500 and the JSE All Share Index hit new all-time highs. But the stand-out is the gold price:

Year-to-date, gold is up 29%, outpacing strong equity markets.

Here’s a fun chart which illustrates how gold retains its buying power over time:

The MWI Worldwide Flexible fund (aka “the cockroach”) has a 14% exposure to physical gold and additional exposure via streaming companies like Wheaton. The fund’s main aim is to preserve purchasing power in US$ terms, so gold will always play a key role in its composition.

My take: The action in gold and stocks is a reaction to central banks’ provision of liquidity to markets globally. Thinking these assets are going up because of economic strength would be a mistake. What liquidity gives, it can take, too.

On the other hand, economically sensitive commodities like iron ore, oil and automaker stocks are struggling. Here’s a chart of iron ore:

And here’s one of Stellantis, maker of cars from Maserati to Opel to Dodge to Peugeot:

Rolex prices confirmed the weak economic environment, having declined by over a third since their highs two years ago:

Bloomberg recently reported that Swiss watchmakers like Girard-Perregeaux were looking for government aid. This is not a sign of strong economic activity.

Last week, the US Fed cut its funds rate for the first time since March 2020 by an aggressive 50 basis points. The South African Reserve Bank followed suit with a more timid 25 basis points. Central banks are easing, which means they are worried about the economy.

Markets often go up in anticipation of central banks cutting rates and decline sharply once that happens. The logic is simple: Central Banks only cut once they are sure of economic weakness, and markets don’t like weakness.

My take: I would be even more cautious than usual right now. Especially when it comes to fundamentally expensive assets.

Since the election in May, The Rand has strengthened significantly. Schalk Louw (follow him on X, @SchalkLouw) of PSG published this chart yesterday on X:

Over the past year, the Rand has appreciated by 10% against the US$!

More importantly, over 5 years, the rand has depreciated by less than the interest rate differential between SA and developed markets. My colleague Daniel King, the CEO-elect of Merchant West Investment, published this chart just over a year ago:

The chart shows that holding Rands and earning local interest rates yields better returns than exchanging Rands into Dollars and earning US interest rates. I wrote about this in Vol1 No 4 – The Path of Least Interest. The recent Rand performance just further substantiates this phenomenon.

My take: South Africa is risky, but you get paid handsomely to take the risk. Unlike most developed markets at this point.

I wrote a three-part series on my views around Bitcoin/Crypto a few weeks ago (you can find them here: part 1, part 2 and part 3).

Today, Bitcoin continues to trade around its all-time high level:

The price of Bitcoin reflects the extent to which excess money is being “printed” by the monetary authorities in the major developed markets. As such it is hard to see it suffering a permanent setback from these levels (famous last words, and all that…).

But if you don’t believe me, here is a talk given by Lyn Alden on the topic. It’s well worth watching if you’re interested in the subject – she explains it much better than I can.

Lyn wrote a book called “Broken Money Why Our Financial System is Failing Us, and How We Can Make It Better.” You can follow her on X at @LynAldenContact.

My take: If you are at all interested in preserving the purchasing power of your wealth over the long term, Bitcoin/Crypto is a useful additional tool in your toolbox. I use it in the MWI Worldwide Flexible fund (aka The Cockroach) for exactly this purpose.

Last week, Microsoft said it would reopen the Three Mile Island nuclear facility. Constellation Energy manages the plant, and the agreement is part of a 20-year plan to provide clean energy to support Microsoft datacenters. The shareholders of Constellation liked the deal:

However, the more important aspect of the deal is that it occurs at the intersection of two strong trends.

The first trend is the massive investment in data centers that Cloud providers and AI developers are making. Data center investment reached over $250 billion last year, with projections indicating that it could exceed $1 trillion annually by 2027. As datacenters expand, their energy consumption is projected to rise dramatically. In the U.S., demand is expected to reach 35 gigawatts (GW) by 2030, up from 17 GW in 2022.

Datacenters need power 24/7. Renewables cannot (yet) provide this. Nuclear can.

The second trend is that nuclear energy is becoming more widely accepted as an alternative clean energy source. If you recall, Three Mile Island suffered a breakdown in 1979. Although no one was injured or even contaminated, it did lead to widespread fear around the safety aspects of nuclear plants. Microsoft’s willingness to restart some of the Three Mile Island reactors shows how public perception has shifted over the past few years.

Doomberg (subscribe here – it’s worth it) sets out the current situation as it pertains to the more widespread acceptance of nuclear energy well in this piece.

Here is an interesting graphic setting out the current and expected nuclear facilities globally:

As with most things concerning energy, China is setting the pace. But the main message here is that nuclear power is back, and the demand for nuclear fuel – uranium Oxide in the form of U3O8, commonly called “Yellow Cake” – can only increase. At the same time, mining output has been curtailed due to a prolonged period of low Uranium prices.

Here is the long-term Uranium price:

My take: The market for Uranium seems to be set up for a classic “capital cycle”, where demand exceeds supply, leading to substantial price increases.

I re-read Joseph Conrad’s classic over the holidays. It’s about an agent who sails up a river somewhere in Africa to find an ivory trader who has become a god-like figure among the local populace. The book explores subjects like colonialism, morality, and mental illness.

The movie “Apocolypse Now” – in my opinion, one of the best movies ever made – was based on this book. It’s not an easy read, but it is rewarding.

In his 300th posting of “The Red Hand Letters”, Nick Cave turned the tables on his readers and asked them:” Where or how do you find your joy?”

He hasn’t given feedback yet, but he did mention something that resonated with me, and I quote: “Joy continues to leap up, unafraid to find us.”

I can’t agree more. Despite everything that happens around us, both good and bad, now and then, a moment happens that can only be described as pure joy. And it is a great moment to live through.

Equally, now and then, someone steals a part of our joy. Interactions with such people should be avoided at all costs. It always seems to be the same person, and they most often find an (anonymous) home on social media.

I’m pretty active on X, and long ago, I decided not to be a joy-stealer. I broke that rule recently when I posted an unnecessarily sharp response to something JP Verster posted. I called him yesterday and apologised to him in person, and I am now doing so publicly. JP, may you continue to find a lot of joy in life, and may I not stand in your joy’s way again.

With that out of the way, all that’s left to say is Shana Tova to all my Jewish family, friends and readers. May the New Year bring you much joy!

Oh yes, and some holiday feedback. Amanda and I visited with our son Zac in London for a few days. Then, she left by train to visit her parents, and I followed her by bike. Here is my bike packing setup (I don’t camp!):

Over three days, I rode for almost 300km through the English countryside, using the app Komoot to navigate. It kept me off the busy roads and on the pretty ones:

Then we were off to beautiful Nice in France, nestled in the foothills of the Alps:

We enjoyed good food and wine, but only once was it as fancy as this!

And beautiful cycling and swimming:

That’s the town of Eze in the background; the final time trial in this year’s Tour de France also went past it.

Now we’re back. So be careful out there!

Piet Viljoen
RECM